Minimizing Trading Risks Using Exchange‐Traded Funds

What Is an ETF?

Exchange‐traded funds, or ETFs, are built with a basket of stocks that track a particular index, whether it’s a large, traditional index such as the S&P 500 or a smaller, more specific group such as biotechnology stocks within the healthcare sector. When you buy an ETF, you buy an index fund that tries to match the performance of that index. Most ETFs are passive trading tools that try to match rather than beat an index.

In the following sections, we outline the benefits and drawbacks of ETFs so you know what you have to pay attention to if you invest in them.

Examining the advantages

You may wonder why using an ETF is a good thing for sector rotation trading. The key advantage is that these funds allow you to actively manage your portfolio based on your analysis of the current sector rotation environment, but without having to take on extra risk from individual stock picks. Plus, there’s no need to worry about an active mutual fund manager making trades that negate the sector rotation analysis because ETFs are passively managed. When you buy a sector ETF, you know exactly what you’re getting.

ETFs offer you a number of advantages:

Minimal managerial risk: The fund manager makes only minor periodic adjustments to keep the fund in line with its index, which mitigates the element of managerial risk. You’re harnessing the power of the index you choose, making it easier to control exactly where your money is invested.
Fewer management fees: Because trading is minimal, the management costs of ETFs are low, so less of your money goes toward fees.
Diversification: By spreading your investment across a wider number of stocks, ETFs keep your portfolio more diversified. They limit your overexposure to just one or two stocks in a sector that you need to research and then closely monitor.
Trading flexibility: They’re traded just like stocks. You can buy and sell ETFs throughout the trading day. Rapid trading triggers no penalties. You can use market orders, limit orders, stop orders, and stop‐limit orders. And, unlike a traditional mutual fund, you can short shares of an ETF. They can also be bought on margin. (Read Chapter 15 for the mechanics of selling short.)
High volumes: They’re often traded at much higher volumes than many individual stocks, which provides greater liquidity. This makes it easy to buy and sell exactly when you want.

The ETF market has grown substantially in recent years, making it easy to find an ETF to match nearly any group you’re interested in. You can find ETFs for any sector you want. You can also find ETFs that match the market cap you want, such as small‐, mid‐, large‐, and mega‐cap companies. You can use them to trade commodities or currencies. Although you may not have difficulty finding an ETF that tracks exactly what you want, you do need to understand how that ETF builds its portfolios (check out the later section “Does Family Matter?” for more on this topic).

Avoiding the flaws

ETFs can be a great way to minimize risk while effectively implementing a sector rotation trading strategy, but they do have some faults that shouldn’t be ignored:

Fees: Every ETF charges fees. Always be sure you understand the fees and carefully compare the options you’re considering.
Volatility: ETFs can be volatile, particularly as you start trading funds with more specific benchmarks such as industry group ETFs that track gambling stocks or apparel retailers. The narrower the focus of the fund, the more volatility it will bring. For example, an ETF that tracks a broad market index will be less volatile than an ETF that tracks a particular sector or industry group. If you pick an oil and gas ETF, it can fall just as hard as any oil or gas stock when the entire industry takes a sharp downturn.
Liquidity: While many ETFs offer high volume and high liquidity, the dramatic expansion of the ETF market in recent years has also resulted in a large number of newer, more thinly traded funds with lower liquidity. Watch the trading volume for any ETF you’re considering for your portfolio. If the trading volume is small, you may have a hard time finding a buyer when you want to get out. One sure sign of low liquidity is a larger spread between the bid and ask prices than those of other funds you’re considering.
Capital gains: Some ETFs pay capital gains. That means you have to pay taxes on the capital gains you receive. If this is a problem for you, you’re better off using only ETFs that reinvest their capital gains.

You’re using ETFs to minimize trading costs and reduce risk. Be sure you don’t add volatility or liquidity problems when you pick your ETFs. Also, you want to minimize your tax hit, so avoid those that pay out capital gains.

Does Family Matter?

Major advisor groups create the ETFs. The ETFs from the same advisor are called a family. Each family is developed based on a set of sector rules established by the advisor for the family. Families can be developed in three ways: market‐weighted, equal‐weighted, or fundamentally weighted. In the following sections, we take a look at how each of the weighting options can impact the ETFs you choose.

Market‐weighted ETFs

Market‐weighted ETFs are based on market capitalization and their underlying sectors. This type of weighting gives you a good exposure to the overall U.S. economy and the sectors in it. They’re biased toward large‐cap stocks and don’t provide much exposure to small‐cap stocks (which tend to be more volatile). Because many sectors have only a few companies that are large‐ or mega‐cap stocks, these types of ETFs can be concentrated in only a few companies. ETFs are available for each of the eleven major market sectors — consumer discretionary, consumer staples, energy, financials, healthcare, industrials, information technology, materials, real estate, telecommunication services, and utilities — as well as the smaller industry groups within those sectors.

As you’re building your portfolio, you should research the indexes each ETF family uses and be sure that the choice of index matches your trading goals. Generally we recommend picking one family of ETFs and sticking with that family to avoid unwanted duplication. Also, this practice will ensure that you’re building a portfolio with the sectors you intend to use.

Two of the largest families managing market‐weighted ETFs are iShares (managed by BlackRock) and State Street Global Advisors. For example, iShares Dow Jones sector ETFs use the Dow Jones U.S. index. This index is a market‐capitalization index designed to represent 95 percent of the U.S. equity market. The managers of these ETFs use the Industrial Classification Benchmark (ICB) system to determine the compositions of each sector and subsector. The ICB classifications were jointly developed by Dow Jones and the British indexer FTSE. (FTSE also develops indexes for many country‐based stock exchanges, such as the Stock Exchange of Thailand and the Cyprus Stock Exchange.) The ICB has 10 industries, 18 super sectors, 39 sectors, and 104 subsectors.

State Street Sector SPDRs, which stands for Standard & Poor’s depository receipts, use the S&P 500 as the underlying index, which includes the 500 leading companies in the United States. They use a different classification system, the Global Industry Classification Standard (GICS), to determine the composition of each sector. This standard was developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P). The GICS has 11 sectors, 24 industry groups, 68 industries, and 157 subindustries.

The GICS takes a market‐orientation approach. For example, it groups consumers into two sectors, consumer discretionary and consumer staples, which both contain goods and services. This differs from ICB, which groups consumer companies by consumer goods and consumer services.

When developing a sector strategy, the market orientation can be a significant difference. Consumer staples are considered noncyclical. Consumers have to buy these products regardless of what’s happening in the economy. Consumer discretionary is more impacted by cycles. As the economy expands and the average consumer has more disposable income, they’re more likely to buy discretionary items such as new clothes or a second car, for example. The consumer discretionary sector includes industries like automobile manufacturers, travel companies, and restaurants. In a grouping by consumer goods and consumer services, however, you get a mix of noncyclical and cyclical stocks.

Understanding the sector composition is crucial for implementing a profitable sector strategy. Always be sure to research the underlying indexes as you choose ETFs for your portfolio.

Equal‐weighted ETFs

Equal‐weighted ETFs give all stocks a similar weighting no matter what size the stock. This weighting assumes that all stocks have the same impact on the index. This type of ETF outperforms a market‐weighted ETF when small‐cap stocks are outperforming large‐cap stocks. Each of this type of sector ETF is rebalanced quarterly to maintain an approximately equal weighting among the stocks in the underlying index.

Because the number of small‐cap companies far surpasses the number of large‐ or mega‐cap companies, this type of ETF needs to do a lot more trading to remain in balance than one with just a few large companies. So be sure to compare your fees with the market‐weighted sector ETF options. Ask yourself: Is paying more worth it to get the exposure to small‐cap stocks? Obviously, when small caps are outperforming large caps, the answer is probably yes.

Two examples of this type of ETF are the Rydex S&P 500 Equal Weight Sector ETFs and the Guggenheim S&P 500 ETFs, which are both based on the S&P 500 index and GICS standard.

If you choose to work with equal‐weighted ETFs, your portfolio will be biased toward small stocks and may not be representative of the overall economy. Because large‐cap stocks are more representative of the economy, this type of ETF may not be the best choice for a sector rotation strategy.

Fundamentally weighted ETFs

Fundamentally weighted ETFs are relatively new to the ETF scene. They’re based on the underlying fundamentals, such as sales, cash flow, book value, and dividends. Companies that are the largest by whatever fundamentals chosen by the ETF manager have the largest weight in the index.

Some players in this market are nine PowerShares FTSE RAFI sector ETFs. The ICB is used to determine the composition of each sector. Information technology and telecommunications have been combined into one sector for these ETFs.

A fundamentally weighted index may be more closely aligned with the overall economy than a market‐weighted one because the weights of the individual companies are based on the size of the company, not just the market cap.

Sector Rotation Strategies

In Chapter 5, we introduce you to sector rotation strategies. ETFs make implementing these strategies easier by minimizing the time you need to spend on individual stock research. You can use that time instead to follow sectors. After you’ve researched and selected the family of ETFs you want to use, you can spend most of your time researching what analysts are saying about where the economy is going. You then can rebalance your portfolio to follow economic trends. In this section, we review those trends and see which sectors do best in which trends.

When using a sector rotation strategy, you’re looking for the sector that has reached a low and is now beginning to show signs of strength. You want to catch the sector that is most likely to recover and rotate in as it begins to strengthen. This is the classic buy low and sell high strategy.

Early recovery

When consumer expectations and industrial production begin to rise and interest rates are bottoming out, you know you’re entering the early stages of recovery. In the early stages of recovery, materials sectors, such as XLB (Materials Select Sector SPDR Fund), and energy sectors, such as XLE (Energy Select Sector SPDR Fund) or IXC (iShares Global Energy ETF), tend to take the lead. Finding the right ETFs in these sectors is a good way to overweight your portfolio as the economy moves into recovery.

Full recovery

After the economy fully recovers, you’ll start to see signs that consumer expectations are falling. Productivity levels and interest rates flatten out. During this economic period, companies in the consumer staples and services sectors tend to take the lead. But be ready to move when the economy heads into its next recession. You should always have some portion of your portfolio in the noncyclical industry ETFs that supply the staples of life, even in times of recession. One possible option may be XLP (Consumer Staples Select Sector SPDR Fund).

Early recession

You can recognize the earliest part of a recession by certain signs: Consumer expectations fall more sharply, and productivity levels start to drop. Interest rates also begin to drop. The utilities, such as XLU (Utilities Select Sector SPDR Fund), and finance, such as XLF (Financial Select Sector SPDR Fund), sector ETFs are ones to hold because the underlying stock prices tend to rise in the early part of a recession. Investors tend to seek stocks that provide some safety and pay higher dividends. Gold and other valuable mineral stocks also tend to look good when investors seek safety. Although the 2008 recession was an anomaly, generally you see banks, insurance companies, and investment firms perform well during the early parts of a recession.

Full recession

You may not think to look at consumer stocks when the economy is in a full recession, but during a full recession consumer expectations actually improve. Spending begins to increase. Yet industrial productivity likely remains flat, and businesses don’t increase their production levels until they believe consumers actually are ready to spend again. Interest rates drop or stay low because neither businesses nor consumers are spending, so credit becomes more available. In the 2007–2009 recession, credit remained tight as banks worked out their problems with mortgage and credit card debt losses. In future recessions, this may not be as severe. During a full recession, ETFs that focus on cyclical, such as XLY (Consumer Discretionary Select Sector SPDR Fund), and technology stocks, such as XLK (Technology Select Sector SPDR Fund) or IXN (iShares Global Tech ETF), tend to lead the way to the next recovery.

Analyzing ETFs

When analyzing ETFs, you need to consider two things: First you must research the underlying indexes and classification benchmarks so you know what types of stocks are likely to be part of the ETF. Then you need to research the fund’s trading history to know how it performed in the various types of markets.

For example, if you believe that a full recession is underway, then you may want to consider weighting your portfolio more heavily with cyclical and technology stocks. Look at the charts for the ETFs you’re considering and see how well they did during the last full recession. Fortunately, because ETFs trade just like stocks on the major exchanges, you can analyze their price charts in almost identical ways. The technical concepts that apply when looking at the chart of a stock are also applicable to the chart of an ETF.

Just like you would for a mutual fund, you want to look at the ETF’s historic performance. Although history is no guarantee the ETF will perform in the same way in the future, it still gives you some reason to base your decision on the ETFs you want to use.

An excellent website for researching what the analysts are saying not only about individual ETFs but about sector choices as well is NASDAQ (www.nasdaq.com/investing/etfs). There you find a treasure trove of ETF stories about where the market has been and where it’s going, along with ETF options to follow the trends. You may want to subscribe to both the latest ETF news and ETF commentary feeds available on this website. The subscriptions are free.

Another fantastic resource is ETF.com (www.etf.com). This site provides an extensive collection of helpful research tools to make sure that your ETF research is as complete and thorough as possible. The site also provides a number of free newsletter services to which you may want to subscribe.

Lastly, Morningstar (www.morningstar.com/Cover/ETFs.aspx) is a good source for ETF research. There you can find a lot of information about individual ETFs as well as ETF trends.

After you’ve done your research, you can pick entry and exit points by using the comparative performance charting tool, PerfCharts, at StockCharts.com (http://stockcharts.com). PerfCharts allow you to dynamically compare the performance of up to ten different stocks or funds on the same chart. Create your own with a unique group of symbols, or use the predefined PerfCharts to analyze popular groups, such as the major market indexes or U.S. commodity groups. To get started, click the tab for Free Charts at the top of any StockCharts.com web page, and then look for the PerfCharts box.

The S&P sector ETFs PerfChart is an excellent tool for visualizing relative strength. It allows you to quickly determine which sectors are moving up and which are moving down, helping you make sure you’re focused only on the top‐performing sectors. The S&P sector ETFs PerfChart on StockCharts.com can be accessed at the following link: https://stockcharts.com/freecharts/perf.php?[SECT].

Portfolio Construction

Constructing an ETF portfolio is not much different from constructing a stock‐based portfolio. You follow the same basic techniques we discuss in Chapters 15 and 16. The only difference is that you use ETFs for building your trading system rather than stocks.

ETFs can be created from trading tools besides domestic stocks, such as commodities and currencies. If you’re more adventurous and understand the risks involved in other types of trading vehicles and strategies, you may want to check out some of the following ETFs.

International trading with ETFs

If you want to add an international component to your trading strategy, ETFs make that much easier. You don’t have to worry about the difficulties of researching international stocks individually. You can just research the ETFs for the countries you want to add to your strategy.

Be careful, though, because now you’re adding in the market risks of international trading, which include currency risks (the fluctuation of currency values among the countries represented in the ETF) and political risks (the politics of every country whose stocks are in the ETF).

Commodities and ETFs

You can also decide to add commodities to your trading mix. ETFs with commodities baskets or single commodities are available. But this type of trading is different, so be sure to study the basics of commodity trading before you start risking your money. If the topic interests you, pick up a copy of Commodities For Dummies, by Amine Bouchentouf (Wiley), before you get your feet wet.

Currency trading and ETFs

You can even trade currency using ETFs. Most major currencies have an ETF that you can trade with a basket of assets in that currency. You can find out more information about currency trading in Currency Trading For Dummies, by Kathleen Brooks and Brian Dolan (Wiley).

Leveraged ETFs

Leveraged ETFs amplify the returns of a particular index by using financial derivatives and debt. For example, a 2:1 leverage fund means that every dollar invested by a trader in the fund is matched with a dollar of debt. Theoretically, if all goes well, the leveraged ETF returns double. So if the index on which the leveraged ETF is based goes up 1 percent, the ETF’s value goes up by 2 percent.

That increase may sound great to you, but the opposite is also true. If the ETF makes the wrong bet on the trend and the index goes down 1 percent, the ETF value goes down by 2 percent. Leveraged ETFs definitely take a strategy for minimizing risks and make it instead a strategy that could compound the risks you take.

Inverse ETFs

If you want to hedge your bets and invest in an ETF that will move in the opposite direction of the index, then choose an inverse ETF. This can provide a simpler alternative to traditional short selling. For example, the ProSharesShort QQQ ETF (PSQ) is the one to choose if you expect a downturn in the NASDAQ 100 Index.

So if you’re expecting the underlying index to go up but you want an insurance policy in case the index goes down, you may choose to balance your trading portfolio with an inverse ETF for the sector you’re betting on.